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ECON 305

Econ Chapter 4  Money and Inflation  Inflation: overall increase in prices  Hyperinflation: episodes of extraordinarily high inflation (500% per month)  Money: the stock of assets that can be readily used to make transactions  Functions of money  Store of value: way to transfer purchasing power from the present to the future  Unit of account: money provides the terms in which prices are quoted and debts are recorded  Medium of exchange: money is what we use to buy goods and services  Liquidity: ease with which as asset can be converted to the medium of exchange  Types of money  Fiat money: has no intrinsic value (dollar bills)  Commodity money: some intrinsic value (gold)  Gold standard: use gold as money or paper redeemable for money  Development of fiat money  Used raw gold  government would make coins so you know it’s pure and the right amount  Government makes paper redeemable for gold (valid if people believe government) • Gold become irrelevant because no one redeems the paper for gold ♦ Everyone values the paper and expects everyone else to as well  Money supply: quantity of money available in an economy  Monetary policy: governments control over the money supply  Central bank: partially independent institution that monetary policy is delegated to.  For the U.S. it is the Federal Reserve (Fed)  Open-market operations: the purchase and sale of government bonds  Primary way the Fed controls the money supply • Increase money supply by buying back bonds ♦ Puts $ into the economy • Decrease money supply by selling government bonds ♦ Takes $from the economy  Measuring the quantity of money  Currency: sum of outstanding paper money and coins  Demand deposits: funds people hold in their checking accounts  M1: demand deposits, travelers checks, currency (directly get)  M2: savings deposits, small time deposits, money market mutual funds, M1 (savings)  Quantity theory of money  Money X velocity = Price X transactions  The more money needed to buy things, the more you hold  T = number of items sold / P = price of typical transaction  PT = dollar value of all transactions  V = transactions velocity of money: rate at which money circulates in the economy • Times a dollar bill changes hands  Must maintain equality (identity)  Transactions replaced with total output (Y) / total income  V now = income velocity of money: number of times a dollar bill enters someone’s income in a given period of time.  Money Demand Function  Real money balances: quantity of money in terms of the quantity of goods and services (M / P) • At current process, the stock of money can buy ___ much of something  Money demand function: equation that shows the determinants of the quantity of real money balances people wish to hold d • M =kY (P) • K is a constant for how much $ people hold for every dollar of income  Quantity theory of money: changes in the quantity of money lead to changes in nominal expenditure.  Velocity constant  PY = nominal GDP • Quantity of money determines the dollar value of the economy’s output  1. FOP’s and production function determine level of output Y.  2. Money supply determines nominal value of output PY  3. Price level P is the ratio of nominal value of output PY to output Y.  Price level is proportionate to the money supply
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